Question

Instructions: For each question, please read the argument carefully and discuss why you agree or disagree with it. You must assess the argument itself rather than other information such as occupations of speakers. Your answer is not subject to any word limit, but a short and concise answer is preferred. Question 1. 10 marks Your financial advisor, Bob, shows two funds, A and B, for your investments and says "I recommend Fund A because its expected return is higher." Do you agree with Bob? Explain why. Question 2. [10 marks In the board meeting, the CFO says, "Our firm's cost of equity is higher than the cost of debt by 3%. We thus must finance the new project by issuing debts rather than equity." Do you agree with the CFO? Explain why. Question 3. [10 marks A food company holds default-free government bonds by 10% of its assets. The treasurer says, "Weighted average of our cost of debt and cost of equity underestimates our business risks." Do you agree with the treasurer? Explain why. Question 4. [10 marks ABC inc. offers a M&A deal to a car manufactoring firm, which can accept or decline it within a year. At the same time, oil producing countries are negotiating to stailize the oil price, which is a key factor for the manufacturing cost of automobile industry. The failure of negotiations will make the oil price extremely volatile. An analyst says, "If the oil price negotiations fail, the M&A offer will deteriorate the value of ABC inc. greatly." Do you agree with the analyst? Explain why.

Answer 1

Q1.

I am not fully agreeing with Bob. Though Fund A has a higher return, I need to consider the beta or systemic risk of each fund. Beta signifies how the fund's return will move in relation to Market's upward to downward movement. A high beta stock will give better return than market when market is good and will give much negative return than market when market is bearish. So Beta is an important factor for fund selection apart from rate of return.

Q2.

CFO is partially right in suggesting that debt fund can be used to lower the cost of capital for projects. As debt will offer tax shields , it will reduce overall cost. However, we also need to consider some other factors like debt service capacity. The project should have sufficient cash flow to cater to the need of interest payment which is mandatory. We cannot blindly increase debt without considering debt service capacity in future.

Q3.

I donot agree with the treasurer. The default free Govt bond is an investment , not a debt . So the return from that bond is an income and does not effect the WACC of the capital employed by the company.

Q4.

The analyst is right. The failed negotiations will imply volatilty in oil price. Oil is not only a manufacturing cost for car oroduction , but the car owners use oil as fuel . So voilatility in oil will impact the disposable income in people's hand that will impact the demand for cars.

So the volatile oil price will impact the car cost of production and the demand of cars as well.

In totality the plan on which the M&A is based may not materialize and that will deteriorate the value of ABC.